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ASK TYLER
Tyler Mordy, President & CIO
[email protected]
@TylerMordy
The US dollar index is at a critical crossroad, recently surging to a 14-year
high as investors bet that Trump’s eye-watering fiscal expansion will prove
a replay of early 1980s Reaganomics.
A cozy consensus is calling for an even higher US dollar. Yet since the start
of 2017 the dollar index has lost its upward momentum. Is an inflection
point approaching?
To be sure, a long list of positives argue for a strong dollar. Most importantly,
Trump’s policies could very well initiate stronger economic growth, higher
inflation and higher interest rates — and hence an even higher dollar.
usd and
icarus: both
too close to
the sun
Will Trump Drive The
US Dollar Higher Or
Lower?
February 21, 2017
But beware consensus thinking. It has been a long period of outperformance
for the greenback. Several factors that drove the dollar higher are now
likely heading in reverse.
First, what expectations are priced in to the dollar? After years of massive
outperformance, opinion is nearly universally bullish, bidding its value
up to hazardous levels. Now, like Icarus soaring too close to the sun, the
dollar’s wings may be melting. For example, in recent earnings outlooks,
CEOs have repeatedly cited the strong dollar as a headwind for growth.
This type of automatic “circuit breaker” ultimately leads to a weaker dollar.
Or consider Trump’s agenda for a manufacturing renaissance. To engineer
this, a weak dollar is crucial. A manufacturing boom without a weak
currency would be incredibly rare.
Trump knows this. Recently, his administration has been talking down the
dollar, complaining that “US companies cannot compete” because of the
strong dollar. Expect this jawboning to continue.
Perhaps more importantly, consider investor expectations for growth
outside of the US. A big surprise in 2017 will likely be much stronger
growth in Asia and even Europe. Recent Eurozone data continues to
paint a picture of accelerating activity, subdued core inflation, ongoing
monetary accommodation, and — most notably for investors — improving
corporate earnings (even France is participating in this cyclical upswing!).
This growth profile is under-appreciated by most investors still fixated on
Trump’s protectionist agenda damaging global trade.
Looking ahead, capital will continue to reward the best macro stories
(particularly those with compelling valuations). Increasingly, these will
be found outside the US.
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Forstrong Global Asset Management Inc.
888-419-6715 | www.forstrong.com
Like other asset classes, currencies have a history of heading into extremes.
The US dollar could certainly move higher from here. But it is a crowded
place with enormously high expectations. Any indication of a stumble
could produce a great rotation out of dollars. Under that view, why not
play a global reflation story by buying Europe and Asia, regions that have
radically sharpened their competitiveness through currency debasement,
are showing signs of earnings and economic acceleration and, if one
insists on measuring valuation (in our post-modern world), trade on much
cheaper multiples?
Currency: A Primer
Speed Read
→ While most investors understand the role that stocks, bonds and even commodities play in a portfolio,
currencies remain opaque.
→ Yet, in a globalized world, currency exposures are having an outsized impact on portfolio returns.
→ Currencies can become wildly overvalued and undervalued; similar to stocks and other assets. Therefore, a large opportunity exists for active currency management.
→ Most importantly, currencies provide some of the best diversification exposures for client portfolios.
Why is active currency management important?
For many investors, currencies are an afterthought; a byproduct of investing in stocks, bonds and other asset
classes in foreign countries. Frequently viewed as an additional source of risk and volatility, it is common
practice to hedge foreign currency exposures back to a portfolio’s base currency.
At Forstrong, currency analysis is an integral part of our investment management process. Exchange rate
fluctuations can have a sizable influence on an economy’s competitiveness, trade balance and inflation rate
(amongst numerous other important implications). Understanding the interconnectivity between currency
and the real economy and formulating an informed view is thus a critical component in the analysis of all
asset classes.
Viewing currencies as a distinct asset class and actively managing exposures bolsters our ability to manage
risk and generate returns. With generally low correlations to domestic stocks and bonds, adding foreign
currency exposure to an investment portfolio helps improve diversification. The ability to create a more
robust and resilient portfolio is the predominant reason why our default currency positioning is unhedged
on foreign asset class allocations.
How does Forstrong implement currency views for clients?
Forstrong gains exposure to foreign currencies through the exchange-traded funds (ETFs) we use to build
client portfolios. Consider the example of a hypothetical Japanese equity ETF, trading in Canada on the
Toronto Stock Exchange (TSX). The ETF exclusively holds stocks which trade in Japan and are denominated
in yen. On any given trading day, a Canadian investor simply sees that the ETF has gone up or down in value.
This daily performance can be broken down into two distinct components: the performance of the Japanese
stocks in local currency (equity component), and the change in the yen versus the Canadian dollar (currency
component). In mathematical terms, this can be represented as follows:
Currency: A Primer
The above example illustrates two active decisions facing the Forstrong Investment Management team:
1. Whether or not to take exposure to Japanese stocks in client portfolios
2. Whether or not to hedge the Japanese yen exposure
How do U.S.-listed ETFs affect currency exposure?
Forstrong also use ETFs which trade in the U.S. to gain exposure to asset classes outside of North America.
A common misconception is that this creates U.S. dollar exposure. Consider the same example of a
hypothetical Japanese equity ETF, but in this case trading in the U.S. on the NYSE Arca Exchange. Daily
performance in Canadian dollar terms will be equal to that of the Canadian-listed version. In the previous example, performance was broken down into two components: equity and currency. In this case,
the equity component is unchanged, as the ETF owns the same Japanese stocks. However, the currency
component requires an additional step. The ETF is exposed to the change in the yen versus the U.S. dollar,
while a Canadian-domiciled portfolio is exposed to the change in the U.S. dollar versus the Canadian
dollar.
This can be displayed as follows:
The U.S. dollar numerator and denominator cancel one another out, leaving a “cross-rate” currency exposure of yen versus Canadian dollars. After this simplification, the currency component is identical to that of
the Canadian-listed ETF.
When does Forstrong hedge foreign currency exposures for clients?
In the above example, an investment in a Japanese equity ETF would represent a favourable assessment
of both Japanese stocks and the yen. However, many times Forstrong’s outlook for a country’s stocks,
bonds and currency run counter to one another. This is especially true for export-oriented nations where
a strengthening currency can weigh on demand from trading partners. Forstrong’s extensive macroeconomic analysis allows us to establish and continually challenge our views across all global asset classes.
We have developed proprietary models to help aggregate and methodically evaluate a broad collection
of qualitative and quantitative data and research. This helps us determine when to increase or decrease
exposure to a particular asset class.
Currency: A Primer
How are currency hedges implemented in client portfolios?
Forstrong use currency-hedged ETFs to lower or remove exposure to currencies we have an unfavourable
outlook on. Once again, consider the example of a hypothetical Japanese equity ETF trading in Canada,
but in this case employing a currency hedge. The ETF will hold the same Japanese stocks, but will also hold
forward contracts to sell yen and buy Canadian dollars. Forward contracts are essentially an agreement
to buy one currency and sell another at a fixed exchange rate on a specified date in the future. In the case
of a currency-hedged ETF holding Japanese stocks, the forward contract exposure is continually adjusted,
such that the amount (or “notional value”) of yen being sold forward offsets the total value of the stocks
held. A forward contract to sell a currency is akin to a short position in a stock, in that it profits if the currency depreciates and loses money if the currency appreciates. This inverse relationship effectively neutralizes the currency component of the ETF’s returns (in this case removing exposure to the yen); leaving
the equity component as the sole contributor to the ETF’s performance.